As part of the series of the "Finance Research Seminar", VGSF welcomes Denis Gromb from HEC Paris to present his research paper.
Conflicting Priorities: A Theory of Covenants and Collateral
Debt secured by collateral is repaid ahead of unsecured debt, even if taken in violation of covenants. We develop a model in which this priority leads to conflicts among debt contracts, but can be optimal nonetheless. Whereas creditors’ option to accelerate following covenant violations can deter dilution by new secured debt, preventing overinvestment, their option to waive covenants allows some dilution, preventing underinvestment. The optimal debt structure trades off over- and under-investment, blocking “bad” but not “good” dilution. It is multi-layered, including secured and unsecured debt with and without covenants. Our results are consistent with several debt structure regularities.